Dow Theory

Introduction

Dow Theory is a unorthodox theory on stock price movements that includes both technical analysis as well as sector rotation. The theory was created out of 255 Wall Street Journal editorials written by Charles H. Dow (1851–1902), the founder and first editor of the Wall Street Journal and co-founder of Dow Jones and Company.

The Dow Theory has been around for more 100 years, and even with the many financial instruments that exist today, the basic components of Dow Theory still remain valid. Dow Theory was refined by William Hamilton and articulated by Robert Rhea, the Dow Theory addresses not only technical analysis and price action, but also market philosophy.

Dow Theory has been used as the backbone to the creation of many other types of technical analysis which include Fibonacci retracements, and cycle measurements.

Background

Charles Dow developed the Dow Theory in the late 19th century based on his analysis of market price action. A book on Dow Theory was never authored by Charles Dow, the main conduit of his analysis were numerous editorials that reflected his views on speculation and the role of the rail and industrial average’s.

Although Charles Dow is credited with developing the Dow Theory, it was S.A. Nelson and William Hamilton who later refined the theory into what we know as Dow Theory today. Nelson wrote The ABC of Stock Speculation and was the first to actually use the term “Dow theory.” Hamilton further refined the theory through a series of articles in The Wall Street Journal from 1902 to 1929. Hamilton also wrote The Stock Market Barometer in 1922, which sought to explain the theory in detail. In 1932, Robert Rhea further refined the analysis of Dow and Hamilton in The Dow Theory. Rhea read, studied and deciphered some 252 editorials through which Dow (1900-1902) and Hamilton (1902-1929) conveyed their thoughts on the market. Rhea also referred to Hamilton’s The Stock Market Barometer.

Dow Theory has 6 different specific principles that define the theme of the analysis. The goals of articles to follow are to define and describe these six different principals. The principles are:

The market has three movements

Market trends have three phases

The stock market discounts all news

Stock market averages must confirm each other

Trends are confirmed by volume

Trends exist until definitive signals prove that they have ended

There are three phases that compose a market trend according to Dow Theory. The first is the accumulation phase, the second is a public participation phase, and the third is a distribution phase. The accumulation phase (phase 1) is a period when investors who are “in the know” are actively buying (selling) stock against the general opinion of the market. During this phase, the stock price does not change much, and most likely will move against the knowledgeable investors because these investors are in the minority absorbing (releasing) stock that the market at large is supplying (demanding).

Eventually, other market participants realize what the knowledgeable investors are doing and a rapid price change occurs (phase 2). This occurs when trend followers and other technically oriented investors participate. This phase continues until a bubble or euphoria occurs. At this point, the knowledgeable investors begin to distribute their holdings to the market (phase 3).

Mr. Hamilton identified three stages to both primary bull markets and primary bear markets. These stages relate to market prices and the physiology of market participants. A primary bull market is defined as a long sustained advance marked increased speculation and demand for stocks. A primary bear market is defined as a long sustained decline marked a decrease in demand for stocks. In both primary bull markets and primary bear markets, there will be secondary movements that run counter to the major trend.

Bull Market

Phase 1 – Accumulation

The first phase of a bull market is no different from the last reaction rally of a bear market. Pessimism, which was excessive at the end of the bear market, still reigns at the beginning of a bull market. It is a period when the public is not investing in the equity market and, the news from corporate America is not comforting. However, it is at this stage that the so-called “smart money” begins to accumulate stocks. Stocks are cheap, but nobody seems to want them.

The first stage of a bull market is where a bottom is created. There are still high volume down days and low volume up days. When the market starts to rise, there is widespread disbelief that a bull market has begun. The market climbs a wall of worry where most people believe the rally should be sold. After the first leg peaks and starts to head back down, the bears come out proclaiming that the bear market is not over. If it is a secondary move, then the low forms above the previous low, a consolidation will ensue as the market firms and then an advance will begin. When the previous peak is surpassed, the beginning of the second leg and a primary bull will be confirmed.

Phase 2 – Large Move

The second phase of a primary bull market is usually the longest and also usually has the largest percentage increase in value. It is a period marked by improving business conditions and increasing valuations in stocks.

Phase 3 – Euphoria

The third phase of a primary bull market is marked by euphoria and excessive speculation. During the third and final phase, the public is fully involved in the market, valuations are excessive and confidence is extraordinarily high. This is the mirror image to the first stage of the bull market.

Bear Market

Phase 1 – Distribution

This is the opposite of accumulation. Distribution marks the beginning of a bear market, as the “smart money” begins to realize that business conditions are not quite as good as once thought, they start to sell stocks. The public is involved in the equity market at this stage and become willing buyers. The market begins to lose its strength and a dull period ensues.

While the market declines, there is little belief that a bear market has started and most forecasters remain bullish. After a moderate decline, there is a reaction rally (secondary move) that retraces a portion of the decline. However, the reaction high of the secondary move would form and be lower than the previous high. After making a lower high, a break below the previous low would confirm that this was the second stage of a bear market.

Phase 2 – Large Move

Phase two of a primary bear market provides the largest move. This is when the trend has been identified as down and the market starts to accelerate to the downside. Earnings estimates are reduced, shortfalls occur, profit margins shrink and revenues fall. As business conditions worsen, the sell-off continues.

Phase 3 – Despair

By the final stage of a bear market, all hope is lost and equities are frowned upon. Valuations are low, but the selling continues as participants seek to sell no matter what. The news from corporate America is dismal, the economic outlook bleak and forecasters predict doom. The market will continue to decline until all the bad news is fully priced into stocks. Once stocks fully reflect the worst possible outcome, the cycle begins again.

The Averages Discount All Information:

The market reflects all available information. Stock prices quickly incorporate new information as soon as it becomes available. Everything there is to know is already reflected in the markets through the price. Once news is released, stock prices will change to reflect this new information. Prices represent the sum total expectations of all participants. Fundamental information such as interest rate movements, earnings expectations, revenue projections, presidential elections, product initiatives and all else is already priced into the market. The unexpected will occur, but usually this will affect the short-term trend. The primary trend will remain unaffected. The Dow Theory of Averages agrees with efficient market hypothesis.

The efficient-market hypothesis (EMH) asserts that financial markets are “information efficient”, or that prices on traded assets (e.g., stocks, bonds, or property) already reflect all known information, and instantly changes to reflect new information. Therefore, according to theory, it is impossible to consistently outperform the market by using any information that the market already knows. Information or news in the EMH is defined as anything that may affect prices that is unknowable in the present and thus appears randomly in the future.

During Charles Dow’s life, at the turn of the century, the US was a growing industrial power. The railroads were a vital link in the economy, because the US had population centers but factories were scattered throughout the country. Factories had to ship their goods to market, usually by rail. Dow’s first stock averages were an index of industrial (manufacturing) companies and rail companies.

To Dow, a bull market in industrials could not occur unless the railway average rallied as well. According to this logic, if manufacturers’ profits are rising, it follows that they are producing more. If they produce more, then they have to ship more goods to consumers. Hence, if an investor is looking for signs of health in manufacturers, he or she should look at the performance of the companies that ship the output of them to market, the railroads. Under Dow theory, a major reversal from a bull to a bear market (or vice versa) cannot be signaled unless both indexes (traditionally the Dow Industrial and Rail Averages) are in agreement. For example, if one index is confirming a new primary uptrend but another index remains in a primary downward trend, it is difficult to assume that a new trend has begun. The reason for this is that a primary trend, either up or down, is the overall direction of the stock market, which in Dow Theory is a reflection of business conditions in the economy. When the stock market is doing well, it is because business conditions are good; when the stock market is doing poorly, it is due to poor business conditions. If the two Dow indexes are in conflict, there is no clear trend in business conditions.

If business conditions cause the major indexes to travel in opposite directions, this disparity suggests that it will be difficult for a primary trend to develop. When trying to confirm a new primary trend, therefore, it’s vital that more than one index shows similar signals within a relatively close period of time. If the indexes are in agreement, it is a sign that business conditions are moving in the indicated direction. Thus, rising indexes signal a new uptrend.

Trends are confirmed by volume

Charles Dow believed that volume confirmed price trends. Volume should increase in the direction of the primary trend. In a primary bull market, volume should be heavier on advances than during corrections. When prices move on low volume, there could be many different explanations why. An overly aggressive seller could be present for example. But when price movements are accompanied by high volume, Dow believed this represented the “true” market view. If many participants are active in a particular security, and the price moves significantly in one direction, Not only should volume decline on corrections, but participation should also decrease. The reaction rallies should also be narrow and reflect poor participation of the broader market. By analyzing the reaction rallies and corrections, it is possible to judge the underlying strength of the primary trend. Dow maintained that this was the direction in which the market anticipated continued movement.

Volume and Reversals

Hamilton noted that high volume levels could be indicative of an impending reversal. A high volume day after a long advance may signal that the trend is about to change or that a reaction high may form soon. This is considered a blow off where market participants who where trading in the opposite direction of the trend finally gave up.